Bush's Achilles' heel?

High U.S. debt ranks as global concern in the year ahead

By

GregoryRobb

WASHINGTON (CBS.MW) - The fact the United States is the world's largest debtor nation is a dark cloud looming over President Bush's second term.

While some economists suggest the cloud could produce a violent storm, others are less concerned. Regardless, the huge U.S. indebtedness and how the White House deals with it will be a pivotal issue over the next four years.

"Global imbalances are the major economic problem facing the world today," says Kenneth Rogoff, a Harvard professor and former International Monetary Fund chief economist.

"The president is going to have to come to terms with this. Otherwise, there could be a major meltdown in the dollar, a drop in global growth and some risk of a financial crisis."

The ultimate wild card is the record U.S. current-account deficit, which is likely to worsen, says Mohamed el-Erian, managing director and head of emerging market funds for Pacific Investment Management Corp.

"We know in the next four years, at some point, the unsustainable will not be sustained," el-Erian says. "The only question is whether this is done in an orderly fashion or a disorderly fashion."

A burgeoning problem

The U.S. current-account -- essentially the checking account for the country-- shows the difference between what U.S. sold to the world and the world has sold to us.

The deficit in the current account has been growing larger for two decades. The deficit hit $164.7 billion in the third quarter of 2004, up 50 percent from $109.8 billion in the last quarter of 2000 when Bush took first office in January 2001.

What troubles economists is the fact that the deficit is approaching 6 percent of GDP, a record size relative to the overall economy. Already, the U.S. has to import $1.8 billion in foreign savings every day to pay for our appetite for imported goods.

Europe and Japan are on the other side of the equation, selling more to U.S. consumers than their citizens are buying from America. China also is sending massive exports to the U.S. while keeping its currency low to also keep the favorable terms of the trade flowing.

How long can this situation continue? Economists don't pretend to know. But economic logic suggests it can't last throughout the next four years of the Bush presidency. History suggests the debtor country will bear the brunt of any adjustment, says Robert Brusca, chief economist at FAO Economics.

Bush policy key

The outline of a solution to U.S. dependence on foreign capital isn't in serious dispute: Higher savings in the United States, a reduction in the growing federal budget deficit and less spending by U.S. consumers, meaning lower GDP growth since consumer spending comprises two-thirds of GDP.

Another important factor has been faster growth in Europe and Asia. Some say the value of the dollar must decline further against foreign currencies to improve U.S. competitiveness. And here is where things get sticky.

The dollar already has dropped 50 percent against the euro and 24 percent against the yen since a peak in February 2002. Europe and Japan are balking at the prospect of any more weakening.

The Chinese currency has remained pegged at 8.3 yuan per dollar since 1995 and the political leadership of China has been wary of altering this anchor. The Chinese political elite are worried that a stronger currency would increase the unemployment rate in China, creating political unrest.

Analysts say the Bush administration may have to lead a coordinated global response to unwind the deficit in a smooth and orderly fashion.

"You would need to see President Bush getting domestic consensus for some increase in national savings and have the U.S. resume its leadership in terms of global policy coordination," el-Erian says.

If the White House doesn't take these steps, "the adjustment burden will be undertaken by the market," el-Erian says. "The risk here is you get a collapse of the dollar and a spike in market interest rates."

El-Erian sees signs the White House wants to improve international economic coordination. "It is a long race. It is not something that will be decided tomorrow. (But) if things stay as they are now, the disorderly solution will ultimately win."

Treasury Secretary John Snow repeatedly has said the administration is committed to cutting the federal budget deficit in half in the next five years. But many analysts are skeptical that Republicans will agree to the necessary steps to reduce the deficit and raise national savings.

Former Federal Reserve Vice Chairman Alan Blinder contends the Bush administration has pursued a "reckless" fiscal policy. "There is a complete loss of fiscal discipline in the United States," says Binder, who was also a top official on the Clinton economic team.

The White House will release the U.S. budget for fiscal year 2006 on Feb. 7. "It will be a tight, disciplined budget with spending under disciplined controls," Snow said. "Everything is being looked at and put under the microscope."

But experts note that Bush's two major economic proposals for his new term don't address the current-account deficit. The Social Security plan would entail massive additional borrowing by the U.S. Treasury and his proposed tax-code reforms don't include new revenue for the government.

"I'm a big fan of Bush's tax-reform ideas, but it is not obvious how you balance the budget at the same time," Harvard's Rogoff says.

David Gilmore, a partner in Connecticut-based research firm Foreign Exchange Analytics, says the dollar will continue downward unless the Bush plan to cut the deficit is deemed credible.

"For the markets, the question is how believable is that policy and the measures (to cut the deficit) that are being proposed," Gilmore says. "If they are not considered credible, then I don't think it does much" to stem the dollar's fall.

Confronting the G-7

Analysts looking for clues to the White House's game plan won't have long to wait -- the G-7 is scheduled to meet Feb. 5 in London.

"There is the potential for a successful meeting, where they can insinuate that the dollar has weakened enough," Gilmore says.

"There is going to have to be horse-trading" before the G-7 would reach any consensus, he says, including fresh signs China will make its currency more flexible, and new pro-growth initiatives out of the euro-zone.

Many economists believe any talk of a financial crisis is alarmist.

PNC Chief Economist Stu Hoffman says he expects the dollar to decline in an orderly fashion this year.

"People who come out with dire predictions that ... the current account deficit will cause interest rates to skyrocket - I would view those forecasts as rather unlikely events," Hoffman says.

Even Blinder agrees talk of dire consequences of a dollar decline have been overblown. "I think the dollar will fall more. Will that ruin our economy? I don't think it will."

In a research note last month. Goldman Sachs Chief Economist William Dudley said Congress and the White House must agree to tighten fiscal policy and take steps to increase household savings, or risk the Federal Reserve taking steps to curb consumer spending and encourage savings.

Wrote Dudley: "If Congress does not do this, the Fed will have to force down domestic demand by raising interest rates."

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